Islamic Finance

Chapter Five: IJARA Contracts

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 1.Overview
• The literal meaning of Ijara is ‘to give something on rent’. As
per Islamic jurisprudence the term connotes two distinct
situations:
• The services of human beings for wages – the mustajir
(employer) employing the services of an ajir (employee) on
wages (ujrah) in lieu of hired services. An ajir for this purpose
can be anyone rendering services including plumbers, doctors
and lawyers.
• Usufructs of assets and properties for rent – transferring the
usufruct of an asset by mujir (lessor) to mustajir (lessee) in lieu
of ujrah (rent) payable by the latter.

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2. What is IJARA?
• Ijara is an Islamic form of leasing. In fact it is
another form of mark-up structure. Here the bank
buys capital equipment or property and leases it
out under instalment plans to end users.
• As in conventional leasing there may be an
option to buy the goods at the end of the Ijara
built into the contracts. This would be an Ijara wa
Iqtina contract. The instalments consist of rental
for use and part repayment of capital.

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3. IJARA Contract

• The bank must exercise all the lessor’s rights and

obligations such as maintenance, insurance and
repair. The lessee gets the use of the asset for the
period of the lease subject to payment of rent. The
lessee may assume the obligations such as
maintenance for a reduced rent. The fact that
there is a real tangible good to be financed means
that this is the most Sharia’a-compliant of the
mark-up products.

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4. IJARA Importance

• Ijara is in high demand and perhaps on its way to

becoming the most popular of Islamic financial
instruments. It provides the appropriate Islamic financial
approach for intermediate or long-term financing of assets.
• Sharia’a rules permit the levy of rental in lieu of granting

the right to use real assets. As the financier undertakes the

risk of the ownership he is entitled to receive a return by
way of rental under the Sharia’a. Normally the rent is fixed
so that the financial institution gets back its original
investment plus a profit. Finance leases or Ijara wa Iqtina
embodies an option to purchase the asset at the end of the
period.

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5. Definition of Usufruct
• This term is used throughout all discussions
regarding Ijara. Usufruct is the right of enjoying a
thing, the property of which is vested in another,
and to draw from the same all the profit, utility
and advantage that it may produce, provided it be
without altering the substance of the thing.

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6. Ijara and Ijara wa Iqtina
• Ijara and Ijara wa Iqtina (also sometimes known as Ijara
Muntahia Bittamleek and defined in detail below) are
unanimously considered by the Islamic scholars as
permissible modes of finance under the Sharia’a, applying
the leasing mode of finance.
• The Islamic Development Bank (IDB), the largest trade
financing institution in the Islamic world, defines leasing as
a ‘medium-term mode of financing, which involves
purchasing, and subsequently transferring, the right of use
of equipment and machinery to the beneficiary for a
specific period of time, during which time the IDB retains
the ownership of the asset’.

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7. IJARA components
• Under the Ijara mode of financing, the bank would buy the
equipment or machinery and lease it out to its clients who
may opt to buy the items eventually. In the latter case the
monthly payments will consist of two components:
• first, rental for the use of the equipment.
• second, instalments towards the purchase price. The
original amount of the rent for the leased assets should be
fixed in advance.

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8. Ijara condition

• An Ijara, or operating lease, is based on a

contract between the lessor and lessee for the
use of a specific asset. The lessor retains the
ownership of the asset and the lessee
has possession and use of the asset on payment
of specified rentals over a specified period.
• Some times, The rentals amount are insufficient
to enable the lessor to recover fully the initial
capital outlay. The residual value is later
recovered through disposal or re-leasing the
equipment to other users.
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9. Ijara wa Iqtina condition

• An Ijara wa Iqtina on the other hand is more like a

conventional financial lease. The rentals during the term
of the lease are sufficient to amortise the leasing
company’s investment and provide an element of profit.
The profit

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10. IJARA scheme of financing

• Under the Ijara scheme of financing, the bank purchases

a real asset (the bank may purchase the asset as per the
specifications provided by the prospective client) and
leases it to the client.
• The period of lease, which may be from three months to
five years or more, is determined by mutual agreement,
according to the nature of the asset.
• During the period of lease, the asset remains under the
ownership of the bank but the physical possession of the
asset and the right of use is transferred to the lessee,
hence the term ‘usufruct’. After the leasing period expires,
the asset reverts to the lessor. The bank and the lessee
agree upon a lease payment schedule based on the
amount and terms of financing.
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11. Definition of Ijara wa Iqtina
• Ijara wa Iqtina is a form of leasing where an asset (building
or physical equipment) is leased by the lessor to the lessee
in a way that, at the end of an agreed lease period, the
lessee becomes the owner of the asset by purchasing it
from the lessor during or at the end of the lease period at an
agreed sale price.
• Given the client’s promise to lease from the bank, the bank
will purchase, for the client and in the bank’s name, an
asset specified in the client’s promise and then lease it to
the client on similar terms to a conventional financial lease.
The lease rental is structured in such a way that at the end
of the lease period, the purchasing cost and profit is
recovered and the bank transfers the ownership of the
asset to the client for a nominal sale price or a gift contract.
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12. WHAT MAKES IJARA SHARIA’A COMPLIANT?

• The Sharia’a allows a fixed charge relating to tangible

assets as opposed to financial assets because, by
converting financial capital into tangible assets, the
financier has assumed risks for which compensation is
permissible. This is one of the key elements making a
transaction Islamically acceptable.
• Since the distinguishing feature of Ijara is that the assets
remain the property of the Islamic bank, it has to put them
up for rent every time the lease period expires so as not to
have them remain unused for long periods of time. Under
this mode of finance the bank bears the risk of an
economic recession or reduced demand for the assets.

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13. SHARIA’A RULES CONCERNING IJARA
• As with the other Islamic modes of finance, the evidence of legality
comes from the Ahadith:
• • Allah says:

. . . and if they suckle your (offspring) give them their recompense.

(Al-Talaq 6)
• Said one of the (damsels): ‘O my (dear father! Engage Him on wages:
truly the best of men for thee to employ is the (man) who is strong and
trusty’.
(Al-Qasas 26)
• the Messenger of Allah said, ‘He who hires a worker must inform him
of his wage’.

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Ijara example
• Calculation of monthly lease rental and total lease rentals

• 1) Formula

a) Total lease rentals (TLR) = CF + (CF × i × n)

• where CF = Cost of financing

• i = Rate of return per annum (flat)

• n = Period of financing in years

b) Monthly lease rental = TLR / N × 12

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Ijara example
• An example

• Cost of financing or purchase price = $30,000

• Rate of profit = 8% per annum

• Period of lease = 5 years (60 months)

• a) Total lease rentals = $30,000 + ($30,000 × 8% × 5)

= $42,000
• b) Monthly lease rental =$42, 000 / 60

= $700
• c) Amount of profit = $42,000 – $30,000

= $12,000

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 Ijara for new car
• How do you Calculate the Rent on a New Car?

• To calculate the monthly rentals simply multiply the cost of the car with the factors
given in Table 5.1
• For example if a customer is interested in a new car costing 300,000 for a tenure of
five years and is willing to pay a 50% security deposit, the monthly rental would be
300,000 × 0.014067 = 4220 per month for five years.
• Security deposit (%) 3 years 4 years 5 years
20 0.030399 0.024789 0.021590
25 0.028821 0.023533 0.020515
30 0.027242 0.022277 0.019440
35 0.025664 0.021021 0.018366
40 0.024085 0.019765 0.017291
45 0.020929 0.017252 0.015142
50 0.019350 0.015996 0.014067
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 Ijara for used car
• What if the Customer Wants to Buy a Second Hand Car?

• If a customer is interested in a car costing 300,000 for a tenure of five years and is
willing to pay a 50% security deposit, the monthly rental can be calculated from Table
5.2. The monthly rental would be 300,000 × 0.014230 = 4261 per month for five
years.
• Security deposit (%) 3 years 4 years 5 years
20 0.029412 0.023940 0.020726
25 0.027799 0.022660 0.019639
30 0.026186 0.021379 0.018552
35 0.024572 0.020099 0.017465
40 0.022959 0.018819 0.016378
45 0.021346 0.017539 0.015290
50 0.019732 0.016259 0.014230

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Exercises
• Calculate the monthly rental payments when buying a
new car, costing 400,000, for a term of five years, if the
potential purchaser is willing to pay a 30% security
deposit.
• Calculate the monthly rental payments when buying a
used car, costing 300,000, for a term of four years, if the
potential purchaser is willing to pay a 25% security
deposit.
• Calculate the monthly rental payments when buying a
new car, costing 350,000, for a term of three years, if the
potential purchaser is willing to pay a 45% security
deposit.

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 Ijara with Musharaka
• The customer and the bank buy a house for £10 million, the bank
contributing 80% of the price, by paying £8 million, and the customer
contributing 20% of the price, by paying £2 million; The price of the house
is further sub-divided into 10 units where the bank owns 8 units and the
customer owns 2 units:
• Assume that the total rent of the house is £75,000 per month, in which case
the rent of one unit is £7500 per month.
• The customer gives its 8 units on Ijara (lease) to the Bank for £60,000 per
month in the first year and so on until the customer takes the full
ownership.
• Required:

• Based on the rental value and the financing period, determine the monthly
repayment schedule that results in the client fully owning the property at
the end of the agreed rental term.

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Solution
• Answers are shown in the following table.
Bank Customer
• Up to the end of Units Rent/month Units Rent/month units purchased
per year
• Year 1 8 60,000 2 15,000 2
• Year 2 6 45,000 4 30,000 2
• Year 3 4 30,000 6 45,000 2
• Year 4 2 15,000 8 60,000 2
• Year 5 0 0 10 Customer is the owner at this point

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 IJARA: OPERATING LEASE CONTRACT
• A bank customer requests financing for five air conditioning units (A/Cs) on
a three-year lease from the bank.
• The bank buys the assets and leases them for three years.

• Financial details US$

• Cost of A/Cs 10,000
• Five-year life – annual depreciation 2000 p.a.
• Insurance (Takaful) 600 p.a.
• Profit required by the bank Year1 900
Year 2 700
Year 3 500
• What is the yearly Ijara rental the bank will charge in order to cover the
costs and to make the required profit?

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Solution
• Answer to Question is shown in the following table.

Year 1 ($) Year 2 ($) Year 3($)

• Bank finance 2000 2000 2000
• Insurance 600 600 600
• Profit required by bank 900 700 500
• Yearly rental charge 3500 3300 3100
• Quarterly rental charge 875 825 775
• Book value after three years is $4000.

****Risk for lessor of default by the lessee

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IJARA WA IQTINA: FINANCE LEASE CONTRACT

• A bank customer requests financing for five air conditioning units

(A/Cs) on a three-year lease from the bank. A bank buys assets and
leases them for three years, with a term of ownership transfer after
redemption of Ijara contract .
• Financial details US$
• Cost of A/Cs 9,990
• Profit required by the bank Year 1 900
Year 2 700
Year 3 500
• The lessee pays the insurance (Takaful)

• Required

What is the yearly rental the bank will charge in order to cover the costs
and to make the required profit?
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 Solution
• Answer to Question is shown in the following table.

Year 1 ($) Year 2 ($) Year 3($)

• Bank finance 3330 3330 3330
• Profit required by bank 900 700 500
• Yearly rental charge 4230 4030 3830
• Quarterly rental charge 1057 1007 957
***Risk of loss is now with the lessee.

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Thank You

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